Regulators Need to Take It Easy on Bitcoin Startups

The recent implosion of bitcoin exchange Mt. Gox — and the loss of almost a half-billion dollars of user funds — is prompting some to call for regulating this and other cryptocurrencies.

But that would be a mistake. Not because protecting consumers isn’t important — it is — it’s just that regulators should balance their goal of protecting consumers with the equally important goal of fostering a climate that welcomes entrepreneurs and innovation. Recreating the internet’s permissionless innovation environment may not be possible in a highly regulated sector as finance. But as regulators look to strike a balance, they should consider creating a safe harbor for small new entrants.

Some bitcoin startups are two-, three- or four-person teams, and as venture capitalist Fred Wilson put it during New York’s hearings on virtual currencies, “It’s very hard for them to do what JPMorgan Chase does. I think there needs to be an on-ramp to regulation that is inviting for young companies to embrace regulation.”

Where the web made it cheaper to successfully start up a company, licensing makes it very expensive to start up.

A sensible safe harbor could be that on-ramp.

Almost every state requires money transmitters, like bitcoin exchanges, to be licensed before opening for business. Getting licensed is a difficult and expensive process, and it’s meant to be that way to weed out fraudsters and operators who don’t have the capital or expertise to successfully run a money transmission business. State licensing requires background checks and net worth minimums, as well as the posting of surety bonds. Licensees must also file anti-money-laundering compliance programs and dutifully comply with examiner requests for information.

The intent behind this type of consumer protection regulation is to prevent scenarios similar to the Mt. Gox debacle. (It’s partly why there are no real U.S.-based bitcoin exchanges.) But this doesn’t just affect bitcoin businesses: Last year Illinois ordered Square to cease business in the state until it obtained a license; Florida granted them one, but only after the company paid a half million dollars in fines for the time it had operated without one. There don’t seem to be any consumer complaints related to either case. So why this regulatory power? Because Square is trying to make it easy for anyone to accept credit card payments, which means it can be considered a money transmitter.

Jerry Brito

Jerry Brito is a senior research fellow with the Mercatus Center at George Mason University and director of its Technology Policy Program. He is the coauthor of Bitcoin: A Primer for Policymakers. Disclosures:Mercatus scholars, who select their own projects, do not do directed research or research for hire. Brito does personally own some bitcoins.

No smart entrepreneur would want to innovate in such a hostile regulatory environment. Especially because licensing, while well intentioned, means that only those with deep pockets can afford to enter the field. Such barriers to entry probably suit century-old incumbents like Western Union just fine. They give internet giants an edge too; Google, Facebook, and Amazon all have money transmitter licenses.

But where the web made it cheaper to successfully start up a company, licensing makes it very expensive to start up. Silicon Valley has been the country’s engine of innovation partly due to its culture of smart risk-taking. Startups are experiments, yet we see too few experiments and too little innovation in the money transmissions space. That’s why the financial industry has been impervious to much-needed change — otherwise, wire transfers wouldn’t cost over $20 and take days (just as they have for decades). There’s no technological reason we can’t have fast and cheap money transfers.

Luckily, bitcoin presents an opportunity to reform the law. Today, dozens of states around the country are working to interpret or update their money transmission rules to take cryptocurrencies into account. New York’s Department of Financial Services has been the most public, holding hearings in January on the possibility of creating a new kind of license for virtual currency businesses. And the Conference of State Bank Supervisors tapped nine regulators — including those from New York, California, Texas, and Florida — to form an Emerging Payments Task Force that will study and make recommendations about virtual currencies and other innovations.

A safe harbor could take many forms, but its ultimate purpose would be allowing startups to jump into the space without compromising consumer protection. (Note that Bitcoin exchanges like Mt. Gox were actually already subject to strict regulations and early complaints.) Under safe harbor provisions, new entrants could be allowed to operate while their license application is pending as long as: they register with federal money laundering authorities; certify that they are well capitalized; and don’t attract consumer complaints. Regulators could also require small firms to clearly disclose their probationary status and post a standard bond pegged to the volume of business they do.

The point of such a safe harbor is to provide a clear path for startups that doesn’t require them to get permission (almost 50 licenses before they even open up shop) to innovate. This kind of balanced approach to regulation would mean not just more bright minds turning their attention to financial innovation, it would mean more investors willing to back their ideas. But most importantly it means the potential to change an outdated, entrenched system for the better.

Tech entrepreneurs have successfully disrupted industry after industry — from journalism to retailing to music and TV — by leveraging the internet-driven principle of permissionless innovation. It’s time for finance to be added to that list. After all, consumers are the ones who benefit from innovation that makes financial services cheaper, faster, and more convenient. Ensuring that consumers are absolutely safe may not make them better off overall if doing so means they only have access to expensive, telegraph-era services.